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Foreign currency ETFs

Institutional investors, banks, and hedge funds traditionally dominated the currency markets. With the advent of ETFs, individual investors now have the ability to gain exposure to this large and tremendously important asset class.

There’s widely differing opinions about whether currency ETFs are appropriate for retail investors. Some argue that currencies offer diversification and the potential to profit from long-term moves which often occur in the currency market. Others argue that it’s an area where retail investors in all likelihood will lose to more sophisticated professional investors who have access to better information and execution capabilities.

In addition, leveraged ETFs which provide double exposure are available on an increasing number of major currencies, including the Euro (URR, ULE), the U.S. dollar (UDN), and the Japanese yen (YCL).

Inverse currency ETFs, which allow you to profit when a currency falls, are available on the Euro (DRR, EUO) and the Japanese yen (YCS).

Multi-currency ETFs are designed to provide exposure to regions or types of countries, and include emerging markets (CEW, JEM) and Asia (AYT).

What Moves Currencies

A variety of factors impact the value of currencies, including:

The direction of interest rates

Economic crises

Global summits that lead to changes in international economic co-ordination

Central bank intervention

Strikes, riots, and political instability

Wars and terrorism

Natural disasters

Government policies impacting the economy and international capital flows

By far the single biggest factor driving currency rates is the direction of interest rates. All else being equal, capital seeks the highest return, and global money tends to migrate to currencies where interest rates are rising and away from currencies where interest rates are falling. In late 2009, for example, Australia surprised the financial markets by raising interest rates at a time when most other countries were lowering rates. The move resulted in sharp spike in value in the Australian dollar, providing a big profit opportunity for nimble traders.

But other factors can override interest rate differentials and investors would be wise to monitor a broad range of economic and political factors before committing to a currency position. Central bank intervention in the currency market – particularly if it is coordinated among different nations – can sometimes lead to a reversal of trend. More commonly, economic reports often spark a short-term reaction in the markets and, at critical moments, may lead to a protracted move. Finally, any sign of political instability such as riots, strikes, or civil unrest usually is negative for a currency.

In most cases, major currency trends occur when a variety of factors coalesce for a period of time, giving impetus to one currency over other currencies. A good example is the appreciation of the Canadian dollar in 2009. Canadian banks were impacted less by the 2008-2009 financial crises than European and U.S. banks; the Canadian economy was stronger than most other countries; and Canada was running a trade surplus. All of that added up to a big move into the Canadian dollar.

Strategies

While any number of strategies can be employed in the currency markets, the most popular are as follows:

Momentum

In this strategy investors attempt to identify a strongly moving currency and, essentially, hop on for the ride. The challenge is to determine whether strong initial move is likely to continue or reverse. Some investors assess whether underlying fundamentals support the move while others may try to measure the strength of the move through technical analysis.

Value

In this strategy, investors seek to identify a currency which is undervalued based on either fundamental factors and/or technical factors. For example, investor may believe that a currency which has been weak for some time is likely to reverse course because of change in the country’s economic direction or policies. Similarly, an investor may decide based on technical analysis that the currency has been oversold and even a small increase in demand will likely lead to a reversal in direction.

Currency Carry Trade ETFs

The currency carry trade is very popular with professional investors. The basic premise is that large interest rate differentials create ideal conditions for a long-term trend favoring the higher yielding currency over the lower yielding currencies. The classic carry trade is to borrow money in a lower interest rate currency and use the borrowed funds to purchase a higher yielding currency.

With ETFs, you could replicate a carry trade through buying the higher yielding currency and buying an inverse of the lower yielding currency. However, a simpler way to execute this strategy is to purchase specialized ETFs that execute carry trades as the core of their strategy.

To the degree that international monetary policies diverge, where some nations focus on combating inflation while others concentrate on stimulating growth, there will continue to be opportunities for currency carry trades.

The Role of Currencies in Your Portfolio

Currency and commodity trading or speculating has a poor public image and conjures up images of investors losing all or most of their capital through ill-advised, highly leveraged trades that they perhaps did not understand and were talked into by unscrupulous market operators. At the same time, it should be noted that a strong case can be made that devoting a portion of your portfolio to currency and commodity assets adds diversification and improves long-term returns. And ETFs are the safest vehicle to accomplish that purpose.

An authoritative academic study issued in 1983 by Harvard professor John Lintner concluded that currencies and commodities reduce overall portfolio risk because they tend to be uncorrelated with stocks and bonds. Linder showed that allocating up to 14% of a portfolio to currencies and commodities reduces overall portfolio volatility.

As with any investment, investors should study the market closely, formulate a strategy, and develop a defined exist and entry before committing capital to any currency ETF.

Article copyright 2011 by Kathy Lien, David J. Abner, and Richard A. Ferri. Reprinted and adapted from The Little Book of Currency Trading: How to Make Big Profits in the World of Forex, The ETF Handbook: How to Value and Trade Exchange-Traded Funds, and The ETF Book: All You Need to Know About Exchange-Traded Funds, Updated Edition with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.

The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Commodity ETPs are generally more volatile than broad-based ETFs and can be affected by increased volatility of commodities prices or indexes as well as changes in supply and demand relationships, interest rates, monetary and other governmental policies or factors affecting a particular sector or commodity. ETPs that track a single sector or commodity may exhibit even greater volatility. Commodity ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the spot price performance of the referenced commodity, particularly over longer holding periods.